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Difficulty: MediumBroker-Dealers, Investment Advisers, and Intermediaries

A retail investor receives a trade confirmation after purchasing 500 shares of a publicly traded technology stock. The confirmation specifies that the firm filled the order from its own inventory and charged a mark-up on the transaction. In which capacity did the firm act, and how is its compensation structured for this trade?

  1. The firm acted as a dealer in a principal capacity and earned compensation via a mark-up.Answer
  2. B
    The firm acted as a broker in an agency capacity and earned compensation via a commission.
  3. C
    The firm acted as an underwriter operating in the primary market directly on behalf of the issuer.
  4. D
    The firm acted as a clearing depository responsible for post-trade custody and trade netting.

Answer

The firm acted as a dealer in a principal capacity and earned compensation via a mark-up.
A broker-dealer operates in a dealer (principal) capacity whenever it buys or sells securities for its own account out of its own inventory. In principal transactions, the firm's compensation is a mark-up added to the price on a customer buy order, or a mark-down subtracted on a customer sell order.

Step-by-Step Solution

1
Identify the trade execution mechanism described in the stem.
The trade was filled directly from the broker-dealer's existing inventory.
Trading from inventory defines principal capacity.
2
Determine the corresponding legal capacity (broker vs. dealer).
When taking the opposite side of a client trade using firm inventory, the firm acts as a dealer (principal).
Dealers trade for their own account and assume inventory risk.
3
Identify the compliant compensation type for principal transactions.
The firm charges a mark-up on purchases or a mark-down on sales.
Commissions are charged when acting as an agent (broker), whereas mark-ups/mark-downs apply to principal transactions.

Key Concept

Broker-Dealer Capacity and Compensation (Agency/Commission vs. Principal/Mark-up)
Estimated Time:1m 0s
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Topics

Broker-Dealers, Investment Advisers, and Intermediaries

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